Over the years, we have seen the development of several tools for predicting the market and making more accurate predictions. You could add the best indicators to your strategy and watch them make a difference in your trades. Similarly, you are better off trading options with indicators, but need them all.
The good thing about options trading is that you don’t need extensive analysis to predict the market. Hence, moving averages (MA) and relative strength indices (RSI) can be enough for your decisions. So, as we go through this guide, remember Steve Clark’s words: “Do more of what works and less of what doesn’t.”
A Brief Look at Options
The trading instruments at the heart of this guide are things experienced traders already know a lot about. First, however, I should explain options trading before jumping into the guide.
For clarity, binary options are not real options. The former differs in many ways, including expiration, the presence of an underlying instrument, etc. This guide explains how to implement moving averages and relative strength indices for real options.
You can identify a real one by the following:
- Long validity period.
- It is available for trading.
- The trade is regulated.
- It is a contract against an underlying listed instrument.
What is an Option?
It is a contract that gives you the right to purchase or sell a stock at a specific price. But, while it gives you the right, it does not obligate you to pay.
The contract can be made in two ways: call and put. A call contract gives you the right to purchase stocks at a specific price (the strike price) for a defined period. On the other hand, the put agreement allows you to sell your stocks at a particular price for a limited period.
Traders use options trading as a form of insurance for the underlying instrument. For example, let’s assume you want to buy 100 XYZ shares, but they cost $100 per share. If you feel the price will increase, you can purchase a call option at $500 for 30 days.
So, even if the stock price rises to $110 per share, you can still buy it at $100. That is the leverage or advantage options give you.
For a further clarity, you may use stock options calculator that you analyze the cost and profitability without any hassle.
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Chart courtesy of Deriv.
Some online brokers provide options trading to their users, just like they would trade tangible assets. Hence, you can buy and sell these contracts for a premium. I do not refer to binary options trading platforms like IQ Options, as they operate differently.
Having options as tradable assets gives you access to the indicators you would use for real instruments. We know several exist, allowing users to customize the price charts and gain valuable insights.
So, you can buy these contracts to protect your assets or trade them directly. The second approach exposes you to technical indicators, just as you would with real instruments. You can view the price movements and gain insight into the market.
Some people prefer using volume-based techniques, but our focus will be on moving averages and relative strength indices. These indicators give a subtle yet powerful interpretation of the market. Also, they complement each other, and using one without the other will be unwise.
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What is a Moving Average and Relative Strength Index?
The moving average and relative strength index are technical indicators for online trades. Traders use the MA to determine a trend and the RSI to see how strong or likely it is to end. They are best used together, as you will see in this strategy.
Moving averages are simply the average prices for a defined period. For example, let’s say you want a 5-period moving average for a price range of $4, $10, $12, $14, and $12. The moving average there will be 10.4 (52/4).
This indicator has several variations: exponential, multiple, triple, double, hamming, adaptive, channel, and weighted moving averages. The key is to pick the one that works best for you and use it in the charts. Then, you will see a new line that follows the price fluctuations.
The moving average smooths the price movements and helps you determine the flow. It is easy on the eyes and more understandable than studying individual prices.
On the other hand, we have the relative strength index. It measures the strength of a trend and how likely it is to be reversed. Hence, traders often pair it with the MA, as the latter reveals the movement.
The RSI does more than determine the strength of a trend. It can also indicate overbought or oversold conditions and help you make better decisions. So, we can learn the following from this indicator:
- Oversold and overbought points
- The divergence points occur when it forms extremes in the opposite direction of the trend. That often indicates the end of a movement.
The values of the relative strength index range from 0 to 100. A value above 70 indicates overbought stages, while a value below 30 indicates oversold stages. These two are what you should avoid when trading options.
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Building Your Options Trading Strategy
Building a strategy with these two indicators is easy now that we have gotten the basics out of the way. You can create a trading strategy with the ALMA, but you might need to catch up on what the RSI offers. Hence, it is best to include both in your portfolio.
Before exploring MA and RSI trading strategies, consider a few terms.
- Stop loss: This feature allows you to exit an unsuccessful trade automatically. You don’t need to monitor the ongoing price movement. Stop losses should also be placed above or below the chosen moving average variant.
- Take profit: This setting helps you avoid holding beyond the overbought regions or selling beyond the oversold regions.
Now for the strategy itself. Here is how to build your options strategy for MA and RSI.
- Pick your instrument by typing its ticker symbol for a quick search.
- Choose options for either call or put. Both sides can be traded.
- View the price trend and add the moving average from the indicators. You can pick any variant that works best for you.
- Use two moving averages. For example, add a 50-period MA and a 15-period MA. One must be long-term and the other short-term.
- Add the RSI to analyze the strengths.
The long or call position
A price that closes above the long-period MA often indicates an upward trend. Use the RSI to confirm your suspicions at this point. If it is above 50, then you have a bullish trend.
You can open a long or call position at this point. Hold your position until the RSI goes above 70 into the overbought region. Then, you can exit your position or close the trade.
Another indication of a bullish trend is if the short-period MA exceeds the long-period MA. In this case, you can open and close a position when the RSI is above 70.
Do not open a position when the RSI is in the overbought region. That often indicates a turnaround or loss of the bullish trend. Similarly, do not sell when the RSI drops below 30.
The short or put position
Quickly identifying a bearish trend is checking if the long-period MA sits above the short-period MA. You can also test the resistance level by looking at the RSI. Finally, open a short or put position if the conditions indicate a downward trend.
Hold your position until the market becomes oversold. You can also use a stop-loss on any MA to exit the market. At this point, you can expect a turnaround.
However, the market may test the resistance but cannot break through. Therefore, you must also consider these scenarios when trading.
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Getting a Terminal
The last step in your strategy is getting a trading terminal. Fortunately, several online brokers support options trading, with some allowing traders to buy the contracts for their stocks. Either one is enough to implement your approach.
Get a broker that supports MetaTrader 4 or has automated trading capabilities. That will help you implement the stop-loss or take-profit features.
Once aboard, remove other indicators from the pricing chart immediately. Next, add the moving averages, both the long- and short-period. Then, monitor their movements.
Add the RSI below to determine the trend strength. Then, you can compare the moving averages with the RSI before opening or closing a trade. It takes a few steps to implement these indicators.
While you warm up to hitting the trading button on options, understand that this strategy is not foolproof. Warren Buffet once said, “Successful investing takes time, discipline, and patience.” Approach things with an open mind.
What to Note When Using MA and RSI—Final Thoughts
On average, 70% of traders take losses every quarter. That is even more than the MA and RSI option strategies are required to provide consistently accurate predictions. Hence, you must consider factors like the economic calendar and other indicators.
The MA and RSI are easy to understand, hence their popularity. It is quick to run analysis and open or close trades. Moreover, tools like stop-loss and take-profit can be handy in maintaining profitability.
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Frequently Asked Questions (FAQs)
- Do I need MetaTrader 4 for options trading with MA and RSI?
You don’t need MetaTrader 4 to use MA and RSI in options trading. However, the platform can add useful features, including stop-loss or take-profit.
- Can I use the moving average in a ranging market?
The feature will be of little help in ranging markets. It will only regain its validity when the price starts swinging and trending.
- What is a moving average convergence divergence?
This feature monitors how two moving averages relate to each other. The formula involves a 12-day exponential moving average and a 26-day exponential moving average.
- What is the moving average used for?
Professional traders use this feature to determine if momentum is changing for a security. It can also indicate an imminent change in the security.
- Should I consider divergence when using RSI?
The divergence on an asset’s price and the RSI indicator may indicate a trend reversal. For example, you can expect a bearish divergence if the instrument’s price hits a high high and the RSI reaches a lower high.
- Is moving averages (MA) a better indicator than relative strength indices (RSI)?
MA is used to determine a trend, while the RSI to see how strong or likely it is to end. These indicators are more effective when used together, than apart.